Contributed By: Brian Sak CFP®, CLU®, ChFC®

Congratulations! By making gifts to a trust, you’ve taken a significant step towards optimizing your financial future and taking advantage of the current tax environment prior to the potential TCJA (Tax Cuts and Jobs Act) sunset. This proactive move helps protect your wealth, ensuring that it benefits your family and future generations. However, this is only the beginning of your wealth management journey. Now that the transfer is complete, there are new challenges and considerations to address.

In this blog post, we will explore what lies ahead after making gifts to trust, the challenges you might face, and effective solutions to ensure your assets continue to grow and benefit your loved ones. Let's begin by understanding some of the key issues that can arise post-transfer.

Losing Basis Adjustment on Transferred Assets

One of the first challenges many face is the potential loss of the basis adjustment in cost basis on transferred assets. When you gift assets to a trust, those assets do not receive a basis adjustment in cost basis upon your death. This means the original cost basis (the value of the asset at the time you acquired it) remains intact, potentially leading to substantial capital gains tax when the asset is eventually sold by the trust. Contrast that with assets owned in your estate, which receive a basis adjustment to their Fair Market Value at the date of death. For highly appreciated assets, this basis adjustment can wipe out a significant amount of capital gain liability.

For example, if you transferred a portfolio of stocks purchased years ago at a significantly lower price, the capital gains tax exposure upon selling those stocks could be considerable. This scenario emphasizes the need to carefully consider which assets to transfer and the potential tax implications.

The lack of a basis adjustment can significantly affect the overall tax efficiency of your estate plan. Therefore, strategic planning and ongoing management of the trust's assets are crucial to mitigate these effects and maximize the benefits for your beneficiaries.

Ongoing Tax Liability in Trust - Capital Gains Exposure

Another challenge that arises is the ongoing tax liability within the trust itself. Non-grantor trusts are subject to different tax rates, and the income generated by the trust, including capital gains, must be managed effectively to minimize tax exposure. Trusts often reach the highest tax bracket quickly due to the compressed tax brackets applying to trust income. For instance, The highest marginal bracket for trusts in 2024 is set at 37% for income over $13,450.

For grantor trusts, the tax liability "passes through" back to the grantor which may result in a more beneficial rate, but may add up to very large amounts over time. This can put a strain on the liquidity available to the grantor for lifestyle purposes.

Understanding the specific tax obligations and structuring the trust's investments accordingly can help mitigate these ongoing tax liabilities. This often involves working closely with tax advisors and financial planners to develop an effective strategy.

Solutions to Address These Challenges

Now that we have identified some of the primary challenges faced after transferring assets to a trust, it's time to explore practical solutions.

Include the Power to Substitute Assets for High Basis Assets Left Behind in the Estate

One effective strategy to manage the loss of basis adjustment is to include the power to substitute assets. With this provision, grantors can substitute low-basis assets in the trust with high-basis assets left behind in the estate. This power allows the trustee or grantor to swap assets of equal value, effectively bringing low-basis assets back into the taxable estate, which can then receive a basis adjustment upon death.

By utilizing this power of substitution, you can optimize the tax efficiency of your estate, ensuring that the assets sold by the trust incur lower capital gains taxes. This strategy requires careful drafting of the trust document and coordination with the trustee to implement it effectively.

Additionally, regular reviews of the trust's holdings and the estate's assets are essential to identify opportunities for substitution and manage the overall tax impact.

Utilize PPLI as an Investment Vehicle Inside the Trust

Another solution to consider is utilizing Private Placement Life Insurance (PPLI) as an investment vehicle within the trust. PPLI policies are designed to combine the benefits of life insurance with investment flexibility, offering a unique opportunity to grow wealth within the trust while minimizing tax liabilities.

PPLI policies allow the trust to invest in a wide range of assets, including private market investments, venture capital, and even real estate while the growth of these investments occurs inside the life insurance policy. This structure provides tax-deferred growth and can result in an effective cost-basis adjustment at death through the tax-free death benefit.

By incorporating PPLI into your trust's investment strategy, you can effectively manage ongoing capital gains exposure and enhance the overall tax efficiency of the trust. It's essential to work with experienced advisors to structure these policies appropriately and ensure they align with your estate planning goals and current governing law.

Leverage Professional Advice and Ongoing Management

Navigating the complexities of post-transfer trust management requires ongoing professional advice and active management. Partnering with skilled financial planners, tax advisors, and legal professionals can provide the expertise needed to address challenges and optimize the trust's performance.

Regularly reviewing the trust's investments, assessing tax implications, and making strategic adjustments are crucial to maintaining the trust's value and achieving your long-term goals.

Key Takeaways and Next Steps

You've successfully taken the first step by making gifts to a trust, but the work doesn't stop there. Addressing the challenges of losing the basis adjustment and ongoing tax liabilities within the trust requires strategic planning and proactive management.

By considering solutions such as the power to substitute assets and utilizing PPLI as an investment vehicle, you can enhance the tax efficiency of your trust and ensure it continues to benefit your family. Leveraging professional advice and ongoing management will be key to navigating these complexities and achieving your estate planning objectives.

To take the next step in optimizing your trust and ensuring its continued success, consider scheduling a consultation with one of our experienced financial planners. Our team can provide tailored advice and strategies to help you manage your wealth effectively and achieve your long-term goals.